The UK's Gilt Complex

July 15th 2023

I still find it surprising that so few people question why Governments should issue debt except in a national emergency, such as a war. I find it equally amazing that politicians are allowed to compete with each other in terms of public spending promises. And, of course, there is little accountability attached to public sector debt - either for issuers or buyers (Largely institutions). Nations can be bankrupted by national debt with no consequences for those who orchestrated the mess. So, maybe I should not be surprised by the chaos in the UK inflation-linked Gilts market in October 2022. Or why the yield on ten-year UK Treasuries now exceeds that of Greek national debt of the same maturity.

But the yield on Government debt is all about inflation I hear you say. Well, not entirely. And, by the way, who calculates that inflation rate? It has become blurred and includes CPI, RPI, core inflation and even trimmed mean. While the public will frequently have a very different view of prices based on personal experience. In the background sits a US economy that has still not retreated in the face of interest rate rises. Not forgetting that 30-year fixed-rate mortgages are commonplace in the US (But not in the UK). If the US raises interest rates, the UK will invariably follow, as it does with many things.

The point I am making is this. The financial markets appear to be asking serious questions about Gilts (UK Government-issued bonds) under a Conservative government. As I write, the odds of Labour gaining the most seats at the next election are 1/7 (Paddy Power). That election will be held by the end of January 2025, at the latest. As it happens, I think Labour will make fiscally prudent decisions. However, we now live in an environment where public spending and public investment have become blurred. Labour needs to get its message of financial responsibility across to investors. And, maybe, it's time to question why the UK Government (As well as most other Governments) need to borrow money at all, especially in this more normalised interest rate environment.

Anyway, my house hunting has ended. I am now resident in Poole, Dorset. From a broader perspective, the exercise reiterated what I already believed. Britain's housing problems are largely intractable. There's a chronic shortage of housing where people want to live. Migration, taxation, demographic change, planning procedures, regional development policies, etc, are complex issues. Sorting this mess out will be incredibly difficult. But there you go. House prices are falling but I don't believe they will collapse - unless mass unemployment kicks in. There appear to be few forced sellers. And although around 1.3 million (m) people are looking at the initial fixed-rate portion of their mortgages coming to an end over 2023, it's easy to forget that around 36% of UK homeowners have no mortgage. While TINA (There Is No Alternative) underpins the residential property market. There seems to be no attractive long-term rental alternative to home ownership for most people in the UK.

And talking of migration in a broader sense, some time ago, I concluded that it was a pretty good barometer of the overall health of a country. People appear to want to move to better pastures. Around that, it's the type of people that want to move. For sure, the UK remains a magnet for those seeking a "Better life", if only for historical reasons and its former empire, as well as the English language. But if the figures from a recent survey produced by Henley Private Wealth Management Report prove correct then the country could be heading for trouble. It appears to be pointing to a migration of the wealthy - they are heading for the exit. I am unsure how a prospective Labour government views this. Many of its spending commitments seem to be based on taxing non-domiciled individuals.

So, back to the portfolio. It started as a poor month but recovered towards the end. That said, much is relative. Take out a handful of US tech stocks (NASDAQ is planning a "Special rebalance") and global markets have generally performed poorly. The lacklustre price of precious metals has impacted my mining stocks. However, they are profitable producers with relatively low costs. While interest rates, a key determinant for the Gold price, are likely to be close to peaking. So, I am not too bothered. However, I am a little surprised, given the sharp rise in interest rates, that the financial system has not started to wobble. And, of course, geopolitical tensions are rising.

Anglo Asian Mining released its Q2 and H1 2023 production and operations review. It re-iterated its guidance production (50,000-54,000 gold equivalent oz). Its total production for H1 2023 fell by around 18.5% compared to the same period last year. Reinforcing its pivot towards Copper production, this rose 42% to 1,860 tonnes. As expected, Gold output from Gedabek continues to fall, down around 30%. It had around US$9.4m in cash at the end of the period. To that could be added a tad under US$10m of Gold and Copper held in stock.

It also announced a forward sale of 4,600 oz of Gold. It plans to sell forward 25%-30% of each month's Gold doré production for the next seven months (June-December 2023) at prices ranging from US$1949.75-US$1979.25 per oz. Not that unusual for a mining company in a period of high capex.

I think this gives a good outline of what the company is aiming to achieve. In essence, a move out of Gold and into Copper.

The key is to replace falling Gold production from Gedabek with new mines and a new dominant output: Copper. Its goal is to produce some 36,000 tonnes of Copper equivalent by 2028.

All good stuff but, as I write, there appear to be rumours on bulletin boards regarding a possible investigation into the company's tailing storage facilities and its impact on the environment. It would be good if could clarify the situation.

Caledonia Mining's Central Shaft project now looks as though it's bearing fruit in terms of exploration. It has facilitated a deep drilling programme - some 5,600 metres this year and it's looking at a further 12,900 metres for the remainder of 2023. The focus is on the Eroica ore body. The results appear good with the ore body continuing at depth. The aim appears to be to move inferred resources to indicated resources and then to produce a revised mineral resource statement. The ultimate goal is to increase the life of the mine. Very importantly, these resources can be exploited without additional shafts. The company can use its existing and planned infrastructure.

On the downside, it's worth mentioning that Zimbabwe is facing a raft of elections in August 2023. These include Presidential, parliamentary and local elections. The backdrop is local currency turmoil.

Centamin issued a pre-feasibility study for its Doropo project. The latter's licence area is some 1,847 square kilometres. However, it asserts that around 85% of its reserves are within a seven kilometres (km) radius. Importantly, there looks to be established national grid connections available (There is an electricity substation around 55km from Doropo). It estimates that commissioning will commence two years after the Final Investment Decision has been taken.

It expects Doropo to have a ten-year life of mine with an average production of 175,000 oz of Gold per annum (pa). Its assumptions were based on a Gold price of US$1,600 per oz (Offering a 2.3 years payback). And with an all-in sustaining cost (AISC) of around US$1,000 per oz. It envisages an open-pit mine with further shallow pits. Total capex is expected to be US$349m with a 10% contingency. The operation is expected to be run on a contract mining basis but it seems to be considering owner-mining.

Although the project has a maiden reserve estimate of 1.87m oz of probable mineral reserves, it appears to believe that this can be increased. It also seems confident in reducing its costs (Both capital and operating).

Doropo looks to be a sound project, in financial terms. However, it will require the displacement of around 2-3,000 people and will impact some 5,000 hectares of agricultural land. The perimeter of the project is also about 7.5km from the Comoé National Park (A UNESCO World Heritage site). So, this will require careful attention. It's not simply about putting a hole in the ground in the middle of nowhere.

The definitive feasibility study is due to be completed in mid-2024. Incidentally, Centamin is holding a webinar at 8.30am BST on Wednesday 26th July 2023.

Fresnillo issued no impactful news over the past month. However, Silver prices have perked up as of late. That seems to have given its stock price a fillip. However, it's also a major producer of Gold and that has dipped slightly. That said, it's profitable and pays a modest dividend. And it has a strong pipeline of projects. But much comes down to the price of Silver.

Golden Prospect Precious Metals announced that its founder and Chairman stood down and his replacement, Toby Birch, had been appointed non-executive Chairman. The former's move had been expected. What this means for the fund's direction, I am unsure. But, frankly, it has been a disappointing performer. I thought its size would have given it greater agility.

Pan African Resources made no notable announcements over the past month. However, construction of its Mogale project is due to commence this month in what was described as an "Official sod turning". Choice words indeed and could be applied to many Boardroom struggles. As with Caledonia Mining, it operates in a tough jurisdiction but it still does the business.

Sylvania Platinum continues with its share buyback programme (It just announced the cancellation of 3,624,275 ordinary shares held in treasury). However, it issued no new news over the month. So, I took a quick look at an Edison report on the company produced in May 2023. And, yes, I know that it's paid for by the company. But its assumptions were based on the following prices for the full year 2023. I have put the current price in brackets. Rhodium US$11,778 per oz (US$4,423), Palladium US$1,711 per oz (US$1,290) and Platinum US$1,000 (US$976). So, unsurprisingly, Sylvania's stock price has been weak recently. But it's a debt-free, cash-rich and low-cost producer that can bide its time.

With its focus on iron ore production and the demand for that output in large measure driven by the Chinese economy, unsurprisingly the following has drifted lower. That reflects the lukewarm market response to China's efforts to stimulate its economy.

Rio Tinto announced a US$498m investment in the North Rim Skam (NRS) area of its Kennecott mine in Utah, USA. The goal is to ramp up its Copper output. Production from the NRS is expected to commence in 2024. Increasing over the following two years to 250,000 tonnes of Copper pa over ten years. In total, it's targeting some 18.5m tonnes of indicated and inferred resources at 3.02% Copper (Plus significant amounts of Gold, Silver and Molybdenum). Incidentally, it's using battery electric vehicle technology for its underground operations, so it's ticking the ESG boxes. It's also in the process of re-building its smelter at Kennecott. In addition, it's spending US$120m on upgrading its refinery tank house structure and its Molybdenum flotation plant. More broadly, it plans to extend the life of the mine beyond 2032. In essence, it appears to be ramping up its productive capacity in parallel with US plans for reshoring and the promotion of clean energy that is buoyed by the Inflation Reduction Act. Much of that reshoring and reshaping of the US energy industry will depend on a reliable supply of (Preferably domestically produced) Copper.

The following gives me exposure to what can be difficult parts of the world for private investors. The first is largely a play on a resolution to the awful conflict in Ukraine. While the second has a strong bias towards Asian technology companies.

JPMorgan Emerging Europe, Middle East and Africa Securities announced its results for the six months ended 30th April 2023. Unlike most investment trusts, it sells at a hefty premium to its Net Asset Value (NAV). To a large degree, it comes down to whether it can eventually realise its Russian assets. However, this gives some idea of what is at stake. As of 24th May 2023, it had the equivalent of ￡11.6m in dividends sitting in a custody "S" account in Moscow. To that could be added a further ￡6.9m in dividends that have been announced but not yet credited. And, of course, that excludes the value of the underlying stocks. While, as I write, the fund is valued at around ￡37m.

With a change in the fund's remit, its portfolio has altered substantially. At the period's end, it held 87 stocks and only 27 were Russian. Around one-third of the fund is invested in Saudi Arabian stocks. Interestingly, since the change it has performed reasonably well against its new benchmark (S&P Emerging Europe, Middle East & Africa BMI Net Return in GBP). It also announced its intention to pay a nominal dividend to maintain its investment trust status. Incidentally, it may be worth remembering that although its investing remit has widened, that still includes Russia.

JPMorgan Asia Growth & Income continues to give me exposure to some great Asian technology companies (Less expensive than their American counterparts). Looking at its latest top ten holdings (I have put the percentage of its total assets in brackets) and these included Taiwan Semiconductor (9.2%), Tencent (6.8%), Samsung Electronics (6.7%), Meituan Dianping (3%) and Infosys Technologies (2.6%). Of course, it's not a pure technology fund but it has the flexibility to move in and out of this growth area. And, of course, it pays a good quarterly dividend based on its NAV.

On both sides of the Atlantic, oilers remain unloved and it's very difficult for them to explain they are part of the solution rather than part of the problem to the world's energy transition.

Over the month, BP floated the idea of selling off its ￡30 billion (b) defined benefits pension scheme. This has some 60,000 members but was closed to new members in 2010. Why sell it? Schemes such as this are assessed as being a liability by credit rating agencies (BP is currently rated -A by S&P). An improvement in its credit rating will likely reduce the cost of future borrowings. I suspect that it may also like to get out while the going is good (According to the FT, it appears to have had a US$4b surplus at the end of 2022). While according to BP's 2022 annual report, each additional year of life expectancy equates to another US$503m pension obligation.

Still growing its green energy portfolio, BP won a €6.8b (Payable over 20 years) contract to build two German offshore wind farms with a total potential capacity of 4GW. Completion is expected by 2030. With some 1,500 EV fast charging points across Germany, it's clearly tapping into the country's green economy.

Trinity Exploration & Production issued what appears to be a positive update on the drilling of its Jacobin well. It claims to have achieved a degree of success and intersected both its secondary targets at a shallow level. These revealed, "...good quality reservoirs and pay zones which have exceeded pre-drill estimates." However, hold your horses, the real prize lies much deeper. In the face of difficult conditions at 9,325 feet, it's now drilling a sidetrack to reach a depth of 10,000 feet. The results of this should be known within two weeks. Thus far, it claims to have discovered a total net 228 feet of "Hydrocarbon pay" across its secondary target areas. Importantly, it states that it has already found "Multiple oil-bearing sandstone reservoirs" in its primary (Lower Cruse) target. Of course, this is an exploration well, so should it prove successful, more work will be required. But, so far, it looks good.

It also announced the results of its AGM. Resolution six relating to the company's authority to issue stock or convert instruments into stock did not pass and resolution seven regarding the issuing of non pre-emptive stock also failed to reach the required majority. Shareholders are restless. Possibly relating to how the company will develop its offshore Galeota assets. Will it dilute current shareholders? Surely, the easiest way for a Board to get resolutions like this passed is simply to buy more stock (Votes). Or else it's asking turkeys to vote for Christmas.

The above takes me to the company's re-evaluation of its plans to develop its Galeota block. It has appointed consultants (Petrofac) to carry out a Concept Screening study to re-evaluate the project in what appears to be its entirety. The findings should be released in September. I find this a little strange as I thought that the only hurdle was financial rather than technical. That said, it seems to be trying to exploit this asset in a way that does not dilute shareholders (Or at least not too much) or saddle the company with huge debts.

Out on a limb, it may be but the following still chugs along (And pays reasonable dividends). But it has proved to be more suited to a bull market than I imagined.

The resignation of CMC Markets' Chief Financial Officer seems very amicable. He will be going in January 2024. I am always a ?little disturbed by abrupt departures. Fortunately, this was not one of them. That aside, it made no major announcements over the past month. However, I am wondering how much of its revenue is from discretionary spending. The one thing it guards closely is the demographics of its clients. Age, sex, occupation, etc, are unknown. Therefore, it can be very difficult to estimate the impact of, say, interest rate increases on its customer base.

My defensive stocks have not held up as well as I had hoped. But they are propped up by dividends.

British American Tobacco announced a significant board reorganisation. Strange, but I am unsure whether this is good or bad. Is it addressing major problems or major opportunities or both? Although it was a short Regulatory News Service (RNS) release, it contained the word "new" 18 times. So, I think it's trying to say something. It has created five additional roles. These are: Chief Operating Officer, Chief Strategy and Growth Officer, Marketing Director, Combustibles and New Categories, Director of Corporate and Regulatory Affairs and Director, Business Development. However, it appears that no new blood will be coming in. This is an internal reorganisation. Both the heads of Reynolds American Inc and New Categories are being replaced. While the roles of Chief Transformation Officer, Chief Growth Officer, Director, New Categories and Director, Combustibles are to be axed. Without detailed knowledge, one can only speculate. I am wondering whether a change in the global regulatory environment has prompted action.

As for a changing regulatory environment, this seems to be gathering pace. With the focus in the UK moving to the waste created by single-use vapes as well as the impact vaping may have on younger people. But I am unsure whether increasing safety standards is bad for the company. Considering that around 50% of disposable vapes sold in the UK are produced by a Shenzhen-based company, I tend to think the opposite.

Capital Gearing Trust's portfolio update for 30th June 2023 was much as to be expected. It holds some 43% of its assets in inflation-linked bonds (UK and US) and has an additional 15% in conventional bonds. As with Ruffer, I believe it's well-positioned for a stagflation environment. Why? Because I think it's likely that raising interest rates to defeat inflation will break something (If it has not done so already - corporate debt refinancing is yet to kick in). That said, some 10.8% of the fund is in 0.125% Inflation-Linked UK Treasury bonds 2024. So, presumably, it doesn't believe that UK inflation will drop in the short term.

Taking a ten-year view of the S&P UK Inflation-Linked Gilt Index, it fell from a peak of 600.78 on 3rd December 2021 to a low of 309.46 on 27th September 2022, largely as a result of the kamikaze Kwarteng budget. As of 7th July 2023, the index was 353.29. I'm unsure what this means. Is the market signalling an end to inflationary pressures? Both Capital Gearing and Ruffer appear to be saying that the market has got it wrong and these Inflation-Linked bonds are undervalued. I think that is reasonable. Costs are under pressure from many fronts: re-shoring, Net zero goals, war in Ukraine, natural resource bottlenecks and labour shortages all spring to mind.

It's also worth remembering that inflation-linked does not mean low risk. Unlike traditional Government bonds, both the principal and the semi-annual coupon payment are linked to the Retail Price Index. I suspect they are more volatile than most would assume. In a benign economic environment, they may seem pedestrian but in a more dynamic situation, they could be very difficult to predict. By the way, the impact of expected inflation on the redemption values of these bonds can be found here at the United Kingdom Debt Management Office. That said, I accept the risk (Deflation - It could be China's next biggest export) and also the potential upside (Inflation). Using figures from the US Federal Reserve's Survey of Consumer Expectations for June 2023, the median public view seems to be that inflation will be around 3% in three years.

Capital Gearing's quarterly report points to a fundamental structural change. Or as it terms it "A regime change". The following are, what I believe to be some of the report's key points.

It suggests we are facing more profound business cycles, volatile inflation and tighter for longer monetary conditions. With the latter having a profound impact on businesses, especially in a global deleveraging. It argues in favour of companies reducing their debt and adopting fixed-rate debt products (I agree with this but I think it may be two years too late!). It also talks of the post-COVID "Everything bubble" - offering investors very few places to hide. Interestingly, it highlights the potential of good quality investment trusts trading at sizeable discounts to their NAVs. Unsurprisingly given its portfolio, it believes that bonds offer one of the few shelters in what could be a turbulent environment.

Unfortunately, I tend to agree with its suggestion that private equity could be a repository for some serious problems. As it points out, most of the private equity debt raised since 2021 in the US and Europe is based on variable interest rates. What possible could go wrong?

It also appears to be taking a more proactive approach to encouraging infrastructure funds to reduce their discounts through asset sales, share repurchases and debt reduction.

As for the pre-eminence of the US dollar, it sees no alternative for international trade. And it clearly believes that its US ten-year Treasury Inflation-Protected Securities are its prize asset.

Although its share buyback programme is still in full swing, as I write, it trades at a discount of around 2% to its NAV.

Ruffer Investment freely admits that its recent performance has been disappointing. The comments below are my take on a conflation of its monthly investment report for May (Published on 20th June) and its June report (Published on 10th July).

Over the past five months its NAV on a total return basis has fallen 6.5%. Still, it's unapologetic about its approach. Its emphasis is on protection rather than growth and it takes a long-term view. That seems to infer that it believes that the downside far outweighs the upside and that's where it's invested. With the financial authorities likely to face a choice between "Monetary stability" and "Financial stability", they are likely to opt for the latter and cut interest rates. And, in fairness, it accepts that timing the market is incredibly difficult and argues that it would rather be too early rather than too late. It points to the cost of its downside protection not being outweighed by the benefits of its growth investments, namely commodities and equities. While its downside protection appears geared toward dealing with persistent and volatile inflation, financial instability (Presumably a stock market crash) and the impact of a recession as a result of the latter. It does not believe in a soft landing for the current economic cycle.

The above largely chimes with my thinking. I believe that squeezing inflation out of the system using interest rates will prove too painful. The financial authorities may need to move the goalposts and accept a new target of 3% inflation. In this case, higher inflation expectations are likely to become entrenched. Incidentally, taking the broad sweep of history and interest rates on both sides of the Atlantic are still at relatively low levels. This is a little worrying as the US Government appears to be heading towards spending some US$1 trillion on US Treasury debt repayments over 2023.

It may only be modest but two of its managers purchased Ruffers' stock over the past month. I have always felt it strange to attend a presentation and find that most senior managers appear unwilling to put their money where their mouths are. That reminds me of an event I once attended. A mining exploration company was trying to raise funds. When asked why he (The CEO) held so little stock in the business, he replied that he had a wife, two kids and a mortgage. Fair enough. But that mindset is not for me.

During the month, Keppler also published a note on Ruffer. Of course, I know it's paid for but it gives the company a chance to put its case. And as it points out, this is one of the rare times when the fund has traded at a discount to its NAV. However, it also highlights that much depends on the fund's inflationary presumptions. If inflation plummets and interest rates hold steady then it could find itself on the wrong side of the market.

My prime concern is whether what has worked in the past will work now. While its goal is to provide a return of at least twice that offered by UK base rates. Not a big ask over the past 15 years but could be difficult in today's interest rate environment.

Greencoat UK Wind made no announcements of interest over the period. It will be holding a conference call on 27th July to discuss its half-year results. A slight digression but I noticed a recent article in The Guardian covering the "Repowering" of an onshore Scottish wind farm (Hagshaw Hill) constructed in 1995 and owned by ScottishPower. It looks set to produce four times as much power as at present but using half the turbines. The read-across seems to be that there may be substantial scope for productivity improvements in the future. ScottishPower is pressing for a streamlining of planning regulations for established sites. So, it could become a lot easier to reconfigure existing wind farms.

NextEnergy Solar Fund announced its full-year results for the period ended 31st March 2023. On the sunny side, its portfolio outperformed against its budgeted expectations. The 3.8% of increased output equated to an additional ￡4.8m in revenue. Not unimportant, its weighted average useful life for its assets was 26.3 years (2022: 27.3 years). While it's targeting an 11% dividend increase to 8.35p per share (1.3-1.5 times covered). It has successfully increased its target dividend every year since 2014. The prospective dividend hike seems quite likely given that it's based on 1-1.2 times fixed revenues and is independent of its capital recycling programme. As for revenue visibility, the following budgeted generation is hedged: 2023/24 (88%). 2024/25 (44%), 2025/26 (13%). Not forgetting that much of its revenue is RPI-linked.

By the way, that capital recycling programme involves the sale of a 236MW subsidy-free portfolio which should reduce its gearing (It has around ￡166.3m in floating rate debt with a weighted average cost of capital of 5.7%). The sale may also facilitate share buybacks - aimed at reducing its discount to its NAV. Its total gearing (Including preference shares) at 45% of its gross asset value is close to its 50% investment policy limit. According to the company, its debt covenants would only be breached with energy prices at ￡20MWh (As I write, the day-ahead price is around ￡130MWh). The Electricity Generating Levy will impact but does not appear overly burdensome.

At the period end, it had 99 operating solar assets, one international solar energy private equity investment, two European solar co-investments (Via a Next Energy Capital private equity fund on a no fee, no carry basis), two joint-venture partnerships in standalone energy projects (It's now changing its mandate so that it can invest up to 25% of its gross asset value in this area).

The predictability of solar power allows the company to exploit arbitrage opportunities throughout the day. So, unsurprisingly, it's looking at retrofitting standalone battery facilities (Co-locating) across its 99 UK solar assets. Simply my opinion but a glance at the numbers seems to reveal that standalone battery storage is a very expensive way of providing energy. For sure, it can be used in an emergency and to assist in balancing the grid. But it's expensive.

And, yes, the kamikaze Kwarteng mini budget hit the company hard. Rising long-term yields on UK Government bonds equated to a rising discount rate applied to the company's unlevered operating UK solar assets. The result was a 7p per share fall in its NAV.

Both the Chairman (And connected persons) and the Chair-elect (She takes up the role in August) made reasonable share purchases over the month. Not huge but it's always good to see managers buying stock in the open market.

Tritax Eurobox still trades at a large discount to its NAV. As I write, this is around 40%. Providing its dividend is secure and that seems to be the case, I'm happy to hold until the commercial property market turns. And, of course, it has a particular niche in the logistics market. It's in a very different market from downtown office blocks. Looking at its news releases over the past month, I have the impression that it has been heavily shorted based on loaned stock. More broadly, I think that it's a good play on Europe's digital economy.

Strange as it may seem, I am quite upbeat about global stock markets. The only concern I have is this. The longer we wait for a financial accident to happen, the worst it's likely to be. Around that, these American technology giants look a little too much like certainties; odds-on favourites that can't lose. They have led global stock markets higher over an extended period. It could be argued that the likes of Apple are conglomerates made up of many businesses, with the parts possibly worth more than the whole. But so were the stock market leaders of the past. So, where does that stock rotation lead us? Will it be another generation of technology stocks? Possibly Indian or Chinese? Or are there gremlins hiding within these huge tech companies?

Just For The Record

Teacher leave them kids a loan seems rather appropriate for this debt-laden generation of graduates.

The Nikkei 225 Index peaked in 1989 and has still not recovered. I hope we are not turning Japanese.

Reaching net zero may well require some Mr Blue Sky thinking.

If this happens, I think NextEnergy will have to reconsider its dividend policy.

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